The Journal’s Tax Story Comes Up Short

Tax structures muddy how small-business owners pay

The Wall Street Journal recently missed a big point about the tax burdens facing millions of small businesses.

Its article “More Firms Enjoy Tax-Free Status” argues that increasing numbers of businesses are organized so “they don’t pay a penny in federal corporate income tax.” That’s true, but as the American Family Business Institute notes, those business owners pay taxes on their business through their personal income taxes.

“Unfortunately, an implication of characterizations like this is that it implicitly calls for hiking individual income taxes, which ensnares more and more family businesses,” AFBI spokesman Charles Chamberlayne said in a statement to InvestorPlace. “For business owners filing via personal income taxes, their family business likely accounts for the majority of what is considered personal income and is subject to a higher marginal tax rate.”

The three main types of flow-through businesses are sole proprietorships, partnerships and S corporations. Business groups such as the AFBI are fighting President Barack Obama’s plan to allow the Bush-era tax cuts to expire and allow for the top marginal rates to revert to their pre-2001 levels of 39% and 39.6%, respectively. This would affect many small-business owners, many of whom don’t make big money.

According to data from Tax Policy Center, the average positive business income for all taxpayers is $39,950. Their profits are likely far more modest since much of their wealth is tied up in their companies.

“… For most taxpayers, positive business income is a relatively small share of their overall income,” Howard Gleckman of the Tax Policy Center wrote in an email. “Only at the top, where it is greater than half of all income for one-third of households, is it a big deal. For many others, it probably represents income from a part-time or sideline business (think money you might make freelancing or a plumber who works for a rental agency during the day but takes on extra jobs at night).”

The Journal, which stands by its story, correctly notes that businesses, sensing the tax advantages, are increasingly organizing themselves under structures that enable them to avoid paying corporate income tax.

“By some estimates, more than 60% of U.S. businesses with profits of $1 million are structured as pass-throughs, the highest rate among developed countries,” the newspaper says. “Their popularity is one big reason why federal corporate tax collections amounted to just 1.3% of GDP in 2010, well below their mark of 2.7% in 2006 and far beneath their peak of 6.1% in 1952.”

The implications for the budget deficit — which stands at more than $1 trillion — are staggering. But a solution also is elusive. Raising taxes on the rich won’t necessarily depress job growth since wealthy individuals are adept at minimizing the reach of Uncle Sam. There’s no guarantee they would create jobs with their tax savings, either.

Business groups and the Republican presidential candidates have argued that the solution to this problem is to roll back the 35% statutory tax rate for corporations. Unfortunately, the answer isn’t so simple. Most corporations don’t pay this rate because they take advantage of tax benefits, known to the public as loopholes.

Moreover, low rates do not equate to prosperity, such as the case in Ireland. Ireland’s corporate tax rate is 12.5%, among the lowest in the world. The impact of the rate on the Irish economy was huge, earning it the nickname the “Celtic Tiger” as scads of Fortune 500 companies including Microsoft (NASDAQ:MSFT), IBM (NYSE:IBM) and Allergan (NYSE:AGN) set up operations on the Emerald Isle.

But the country’s fortunes have changed in the past few years. In 2010, Ireland needed a $113 billion bailout in 2010. Recently, Ireland had the second-worst-performing eurozone economy behind Greece in the third quarter, and it slashed its GDP forecast twice in December. Now there is speculation that the country will need a second bailout.

People have an almost primal instinct for figuring out how to pay the least amount of money to the government. That explains why so many businesses are forming flow-through businesses and why — for now — the IRS can do little about it.

As of this writing, Jonathan Berr did not hold a position in any of the aforementioned stocks.

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